Sunday, June 28, 2009

Is Treasury's TARP Debt Already Monetized?--Part Two

My post from Friday June 26 contained the first part of this discussion. Today I would like to continue the discussion and there are two reasons for doing so. The first reason is to understand just what the Federal Reserve has been doing over these last nine months. The second is to understand how likely it might be for the Federal Reserve to “unwind” what it has done over the past nine months and reduce a part of the fear of future inflation. Note, I am not including any discussion of future government deficits and the probability that they will be “monetized.”

There is no doubt in my mind that the Federal Reserve has “printed” a lot of money since early September 2008, most of it before January 2009. The Monetary Base (Non-seasonally adjusted, NSA) rose from $847 billion in August 2008 to $1,712 billion in January 2009, an increase of $865 billion. Between January and May 2009, the Monetary Base only rose $63 billion.

Total Reserves (NSA) in the banking system increased by $817 billion from September 2008 to January 2009, but only increased by $42 billion since January. The most interesting thing is that Excess Reserves (NSA) in the banking system rose by almost $800 billion in the earlier period and increased by $46 billion in the January to May period.

The Federal Reserve put a lot on money into the banking system over the last nine months and the VAST MAJORITY of the funds went into Excess Reserves. The Fed “printed” a lot of money (or, created a lot of deposits at the Fed) but these monies did not find their way into the economy!

These two periods need to be separated in order to get a better picture of what the Fed has done and for some implications about what might occur in the future. My basic argument is that the Fed has put a tremendous amount of money into the world banking system and has ultimately underwritten the Treasury’s TARP program and provided much more money to the banking system than Congress authorized.

The underlying effort has two goals: first, to keep financial markets liquid; and second, to protect against the insolvency of the banking system. The first goal has basically been accomplished. The second is still playing itself out. The crucial thing to understand is that the way the Fed has acted has given the system a chance to get healthy and yet provide a net to catch insolvent banks so as to avoid a precipitous collapse of the banking system.

In the September 2008 to January 2009, the crisis period, the Fed basically ceased using the normal tools of monetary policy: open market operations consisting of outright purchases of government securities and repurchase agreements. In the fall, the Federal Reserve basically picked and choose what parts of the financial markets needed liquidity and created facilities to support these ill-liquid sub-markets. The major ways that it supplied funds or saw funds withdrawn in the September 2008 through January 2009 period and in the January 2009 through May 2009 period.

Change (billions) from Sept/08 to Jan/09: Term Auction Credit $257; Other Loans $166; Commercial Paper LLC $334; Other Fed Reserve Assets $506; for a total of $1,263. The change (billions) from Jan/09 through May 2009: Term Auction Credit (-$124); Other Loans (-$62); Commercial Paper LLC (-$206); Other Fed Reserve Assets (-$411); for a total of minus $803.

The Term Auction Credit Facility (TAF) helped to get reserves to the commercial banks that needed reserves, an effort the Fed believed was more efficient than open market operations. TAF peaked at $300 billion increase on 12/31/08. Other loans include increased borrowings from the Fed’s discount window, a facility for asset-backed commercial paper (which reached a peak increase of $152 billion on 10/8/08), a facility for primary government security dealers (which reached a peak increase of $147 billion on 10/1/08), and a facility for AIG. The commercial paper LLC was a limited liability facility that bought 3-month paper from eligible issuers (which reached its peak of $334 billion on 12/31/08). The increase in Other Fed Reserve assets was primarily Central Bank Liquidity swaps (which reached a peak of $682 billion on 12/17/08).

However, the Fed’s efforts reported here resulted in almost a $1.3 trillion increase in its assets and an $865 billion increase in the Monetary Base. Thus, almost the entire monetization ended up as excess reserves held at Federal Reserve Banks. Bank reserves at Federal Reserve Banks increased steadily throughout the fall, peaking at $856 million on December 31, 2008. Whew! The Federal Reserve had made it through this period of financial market illiquidity which accompanied the entire Thanksgiving/Christmas seasonal need for cash.

What happened in 2009? As mentioned above, the needs of specific market makers retreated, but now the solvency of the banking system came to the fore. In terms of the special facilities, as can be seen from the figures given above, a total of $803 billion was removed during the first five months of the year. Then the Fed began to conduct open market operations again. Throughout this time, securities bought outright by the Fed increased by $712 bullion. This included a program to buy government securities on a regular basis which contributed $177 billion to the Fed’s portfolio. It also added $70 billion of Federal Agency issues. Furthermore, the Fed initiated a very important program in 2009 and bought $465 billion of Mortgage-backed securities.

In essence, Total Federal Reserve Bank credit declined by about $200 billion during the first five months of the year but, as was reported earlier, the monetary base increased by $63 billion and total reserves and excess reserves in the banking system increase by more than $40 billion. In essence, the Fed operated in 2009 to keep the banking system very liquid and replaced the reserves that had been supplied to different parts of the financial markets in 2008 by interjecting funds directly into the banking system. The new twist? Directly helping banks sell their mortgage-backed securities, thereby reducing pressure on the banks to clean up their balance sheets. This was the original purpose of the Treasury’s TARP program.

The banking system faces three problems going forward: existing bad assets; bad assets that will appear over the next 18 months or so; and refinancing needs as the banks may not always be able to roll over existing liabilities.(See my post of June 15, “What Banks Aren’t Telling Us”,, for more on these factors.) The huge amount of excess reserves will help the banks face these problems. In terms of financing needs, the banks have the cash to pay off maturing liabilities without needing to roll the debt over. In terms of bad debts, this is where the TARP program comes in because the Treasury has provided preferred stock to banks with warrants attached. Charge offs can go against existing capital and the preferred stock and warrants can be transformed into new capital owned by the government to keep these banks afloat until something can be done with them.

Some banks have repaid the TARP funds that they had received. Several well-known large banks returned $68.25 billion this month to reduce Federal Government oversight. Still there have been 633 banks that have directly received about $200 billion in TARP funds and a total of 32 banks have now repaid about $70 billion. (On this see “Small Banks Not Shying From TARP” in June 27 Wall Street Journal, So, of the roughly $800 billion that banks are now holding in excess reserves, one could argue that approximately $130 billion of them have been supplied through the Treasury program and are held, mostly, by smaller banks and $670 billion of them has been supplied by the Federal Reserve, the total of the two being the money “printed “ to get us out of the current financial crisis.

The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!

Thursday, June 25, 2009

Treasury's TARP Debt Already Monetized?

Where does all the TARP money show up? TARP, of course, stands for the Troubled Asset Relief Program that became law on October 3, 2008, a program aimed at providing support for the banking system. The program was initially intended to provide liquidity-help for the troubled assets that were on the balance sheets of banks but it soon morphed into a program to support troubled banks in their capital needs as funds were made available to purchase senior preferred stock and warrants from commercial banks and other troubled financial institutions.

The first $350 billion of funds was authorized to be released on October 3, 2008 and Congress approved the release of the next $350 billion on January 15, 2009. Part of the concern with the program was that the government deficit would have to increase by $700 billion in order to create the funds. Concerns arose about how the Treasury Department would finance these payments?

One quick answer was “let the Federal Reserve monetize the debt?”

What if the Federal Reserve has already monetized the debt related to TARP? If this is the case, then two questions that have been puzzling me have answers to them. The first question relates to the increase in excess reserves in the banking system. The second question relates to the concern about how the Federal Reserve will reverse out all of the reserves that it pumped into the banking system last fall. Let’s look at both in turn.

Federal Reserve Bank Credit has increased by $1.2 trillion since just before the financial meltdown in September 2008. What has increased the most in the banking system? Excess reserves in the commercial banking system have risen by about $800 billion. Excess reserves in the WHOLE banking system had run about $2 billion before September 2008. Something unprecedented obviously took place!

In terms of policy making the creation of TARP and the response of the Federal Reserve are closely tied together. (See my post of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?: As mentioned above, the first round of TARP was released in October. But, the Federal Reserve could not wait. It began pumping reserves into the banking system in the latter part of September increasing Reserve Bank Credit outstanding from about $890 billion on September 10, 2008 to $1.5 trillion on October 8, $1.9 trillion on October 29, and $2.2 trillion on November 19.

In all this action, what happened to reserve balances at the Federal Reserve? They went from around $8 billion on September 10, to $175 billion, to $420 billion, to $624 billion, respectively, on the same dates as above. Excess reserves in the banking system averaged $2 billion in August, $60 billion in September, $268 billion in October, $559 billion in November, and $767 billion in December.

Excess reserves in the banking system averaged $844 billion in May and are averaging around $800 in June. Clearly a lot of money!

The question is “Why are the banks sitting on such large amounts of basically idle cash?”

My response is that they are sitting on this cash because it is connected with the receipt of TARP monies and the banks are hoping, as some of the larger and stronger institutions have done, to repay the funds as soon as possible.

Let’s look a little closer at the data. I am using information from the H.8 release put out by the Federal Reserve System on assets and liabilities of all commercial banks in the United States. Year-over-year, through May 2009, total assets in the banking system increased by 9.7% or about $1.1 trillion. Cash assets in the banking system increased a whopping $731 billion or at a year-over-year rate of 236%. This is comparable to the year-over-year increase in excess reserves observed on the H.3 release of the Federal Reserve providing data on bank reserves.

Given my post of last June 15, 2009, “What Aren’t Banks Telling Us?”, ( I was interested in looking a little deeper into this information to see how these excess reserves were distributed within the banking system. Roughly the division is this. The increase in cash assets at large commercial banks was $371billion, at small banks the increase was $143 billion, and at Foreign-related Institutions in the United States, $217 billion. The increase at the larger institutions, the large banks and the foreign-related institutions, was $588 billion and this represented the immediate problem to the policy makers. The problems of the smaller banks could be dealt with later.

The reason I am interested in looking into this distribution is the claim made in the above-mentioned post that commercial banks had not been fully open with the public on the problems they were still facing. In that post I mentioned three areas of concern: the bad assets now on the books of the banks; the anticipated increase in the bad assets in the upcoming months; and finally, the needs of the banks to be able to fund themselves in the future in the face of liabilities that were maturing and would not be rolled over. The build up in cash assets, it was argued, was a precaution the banks were taking to handle the uncertainty they faced as either asset values fell or a run off of liabilities forced the banks to dispose of assets.

Here is where the TARP money comes into play. If TARP money went into preferred stock and warrants, then these monies could be used to provide capital to the banks as the banks needed to write off bad loans and securities. The stock could even be converted into capital if the funds were needed to keep the banks solvent. Otherwise the banks could use the TARP funds to pay off maturing debt that could not be rolled over in the financial markets. (See Gretchen Morgenson, “Debts Coming Due At The Wrong Time,”,%202009&st=cse.) Thus, monetizing the TARP debt makes a lot of sense in that it helps to protect the banking system from either bad assets that have to be written off or from financing problems resulting from the inability of the banks to roll over maturing liabilities.

What does this have to do with the Federal Reserve being able to unwind all the Reserve Bank Credit that it has pumped into the system? Well, when the banking system gets its act in order and charges off the loans and securities that it needs to and when its refinancing needs are satisfied, banks can then repay the TARP money to the Treasury as have the large financial institutions that have already repaid the TARP funds that they received. And, as the TARP monies are repaid, Reserve Bank Credit will decline so as to reduce the concern over the Fed monetizing the federal deficit.

Nice trick! The policy makers have provided a net under the banking system if the situation gets too bad in order to protect it against things falling apart and parallelizing the financial system. And, they have built into the system the means of reducing reserves as the financial system strengthens so as to avoid concerns over possible future inflation.

One final question: have the actions of the Federal Reserve had any impact on bank lending? The answer is “Not Really!” Year-over-year, loans and leases at all commercial banks increased by a tepid $182 billion or at a 2.6% annual rate. And, where were these increases located? Generally in home equity loans, consumer loans, and other residential loans (primarily mortgages) satisfying consumers needs for ready cash through consumer credit or the refinancing of homes. And, these loans were pretty evenly spread throughout the banking system.

Bottom line, however, is that the banks aren’t lending! Especially in the areas of commercial and industrial loans and commercial mortgages. Does that tell you something?

Sunday, June 21, 2009

A Walk on the Supply Side

Keynesian demand-side economics still rules the minds of the policy makers in Washington, D. C. Their actions and their analysis continually point to their focus on aggregate demand and the “green shoots” that are expected to accompany an economic recovery based on the stimulus of spending.

For over a year I have been arguing that more attention needs to be given to the supply side of the equation. Yes, the growth rate of real GDP has been going down and the rate of employment has been going up. But, the rate of inflation, as measured by the rate of increase of the GDP price deflator has not declined since the fourth quarter of 2007. If it were just a demand side problem, this would not be the case.

I focus on the rate of increase in the GDP implicit deflator because of some of the measurement problems associated with the Consumer Price Index, such as the treatment of housing expenses and energy. Certainly, the CPI should be watched, but in dealing with economic aggregates, I prefer the former.

My point has been that if the problems in the economy were all tied to a substantial fall in aggregate demand, then there should have been a more substantial lessening in the rate of price increases. Consequently, my argument has been that something has happened on the supply side of the economy for the numbers to have been reported as they have been.

I would like to point to two areas of the United States economy that indicates that the problems of recovery may be more difficult to overcome than if the dislocation in the economy were just one of inadequate aggregate demand. The first area is that of industrial output; the second area is the labor market.

In terms of the industrial base of the economy I would like to focus upon industrial production and the industrial utilization of capacity. Industrial production has been declining steadily since the start of the recession in December 2007. At that time, industrial production was growing at about a 2.0% year-over-year rate of growth. By April 2008 the year-over-year rate of growth had become negative. The figures for 2009 are
January -10.8
February -11.3
March -12.6
April -12.7
May -13.4

This certainly shows a continuing weakening in the economy. However, taken by itself I don’t think that it carries more meaning than does the decline in the rate of growth of real GDP which has been declining as well.

Combine this performance with the figures on capacity utilization and one gets a different picture. As expected, total industry capacity utilization has dropped substantially in this recession. In December 2007, the figure stood at a little over 80.0%. In May 2009, capacity utilization had fallen to about 68.0%. This is the largest 18 month decline in the post-World War II period.

But, this is not all. The peak in capacity utilization in the past ten years was only slightly more than the December 2007 figure. But, this peak of the last ten years was substantially below the level of capacity utilization for most of the 1990s which was below the peak utilization in the 1970s which was below the peak utilization in the 1960s. That is, it appears as if we have been using less and less of our capacity on a regular basis since the 1960s.

The structure of our industrial base is changing. We can see that in autos, in steel, and in many other parts of our manufacturing base. It appears as if the weakness in our economy is composed of two things: first the cyclical swing in business; but this weakness is on top of a secular decline in our productive ability. The economy is in the process of restructuring!

This shift is also showing up in labor markets. The civilian participation rate in the labor force for the United States rose from the late 1960s into the 1990s when it peaked a little above 67.0%. The civilian participation rate has declined since late 2000 and has remained below 66.2% since 2004. In terms of the number of people who are not participating in the labor market any more, this represents a large number. People have left the labor force in the last five or six years and this trend has, of course, been exacerbated by the recession. Over the past forty years the rise in the participation rate has slowed down or stopped during recessions, but at no time did it decline as it did in the in the past six years.

Of further interest, the Labor Department reported that separations from jobs in April remained relatively constant as they have for the past two years, but the rate of hiring continued to be quite low. In early 2008 the percentage of the labor force that were separated from their jobs was about equal to the percentage that were being hired. Since then separations have exceeded hirings, as might be expected, causing the unemployment rate to rise.

In terms of those that were separated from their jobs, there was a dramatic shift between those that quit their jobs and those that were laid off or discharged from their jobs. The percentage of layoffs and discharges rose dramatically from April 2008 to April 2009 whereas quit levels dropped substantially. That is, although separation rates did not change much at all during this time, the composition of those being separated from their positions experienced a tremendous shift. This is an indication that there is a structural shift in what is happening in the labor markets.

This information leads me to believe that there is a substantial restructuring taking place in the United States economy. And, a structural shift is a supply side issue and not a demand side issue. In fact, demand side responses can just make a bad situation worse by trying to force people back into positions that companies and industries are attempting to eliminate because the world has changed.

The figures on industrial production and capacity utilization seem to indicate that industry is changing and the numbers from the labor market reinforce that conclusion. Pumping up aggregate demand is an attempt to stop this restructuring or, at least, slow it down.

The problem that policymakers’ face is that they, or we, do not know what the new industrial structure is going to look like. It is impossible for anyone to know. People can make guesses, but that is all they are—guesses. And, in situations like this, it is more likely that the guesses will be wrong rather than being right. It’s just that the future is unknown. The need for the United States economy to restructure just adds another “unknown, unknown” to our list of “known unknowns” and “unknown, unknowns.” My guess is that this restructuring is going to take some time and could be sidetracked by huge government deficits and a supportive monetary policy.

Thursday, June 18, 2009

Financial Well-Being and Regulation: the Obama Effort

Financial well-being is, in many ways, analogous to our physical well-being. We need periodic check ups and doctoral oversight, but in general true health is dependent upon the discipline and persistence and care that we bring to our own daily lives. However in other ways financial well-being in not the same. Our physical existence is limited to our natural selves: there are limits to how humans can grow and change. This is not true of the financial system.

In the world of finance we can innovate and change and find ways to get around regulation. This has been the modus operandi of the financial system during my entire professional career. Consequently, the financial system of today in substantially different than the financial world that existed in the 1960s. I have called the last fifty years or so the age of financial innovation. Regulation and oversight of the financial system does have to change. But, we need to be careful about the change in regulation and oversight that results and not just give in to populist calls to “put a stop to the greed on Wall Street”.

The characteristic about finance that fails to be taken into consideration when people believe that they can “control” finance is that finance is about nothing more than information. Finance is numbers, nothing more, and numbers can be packaged in any way that a person wants to package them. On our currency we read that “This note is legal tender for all debts, public and private.” That is, people and governments can pay you for things in this script and you must take it. And, what more is a check, or a bank deposit, or a bond, or a stock certificate? In most cases today, these are nothing but 0s and 1s in a computer system. Finance is nothing more than information and how information is handled and transformed.

The unique thing about information is that it spreads and, as we have found out historically, information cannot be contained. Of course, its spread can be postponed or stymied for a while, but eventually its spread takes place. All human history is a record of this fact.

We see this trend also works in non-financial areas. Information relating to modernity and science and democracy is spreading throughout the world. In some areas this spread is being resisted by some who are attempting to keep the world mired in the ideas of the 7th or 8th century (C. E.) This attempt to prevent the spread of the idea of the modern world has resulted in violence and tremendous pain to many. But, the spread continues. It has all through recorded history. In the end, the resisters cannot stop it and their efforts to slow it down do nothing but cause unhappiness and dislocation.

The financial system over the past 50 years or so has been an engine of new creations. In the 1960s, we saw the movement of banks from being asset managers to becoming liability managers through the creation of instruments like the negotiable certificate of deposit and Eurodollar accounts. This broke down the geographical limitations on banks and helped them continue to evade government rules and regulations. In the academic world increases in computing power combined with the vast amount of data available on the stock market allowed for the development of ideas relating to portfolio management and risk control, which culminated in the creation of CAPM and the efficient markets hypothesis. A third innovation related to the growth and development of venture capital that put money into the hands of more and more innovators starting up small businesses. All of these developments had to do with information and how that information was bundled and traded.

In the 1970s we saw the development of the mortgage backed security, the junk bond, and the leveraged buyout. The creation of the mortgage backed security by the federal government was the test case for “slicing and dicing” up cash flows into tranches that could be packaged in ways that met the specific needs of different investors. And, as they say, the rest is history.

The development of the junk bond? The legend is that Michael Milken, sequestered in the bowels of the Lippincott Library of the University of Pennsylvania discovered information about the performance of “fallen angels”. These were high quality bonds issued sometime in the late 1920s or early in the 1930s whose companies had had financial difficulties. The bonds fell out of favor and hence yielded very high returns. Milken discovered that because of the lack of interest in these securities their actual performance substantially exceeded the performance exhibited in their market pricing. This information, which was confirmed by more current information, led Milken to develop the junk bond, the first such issue coming to market in 1976.

In addition, fund managers arose, like KKR, which discovered information concerning the value of assets that were on the books of many corporations. Often, these assets were undervalued because they were recorded at historical values and were substantially below current market values. Previously, these companies were “out-of-reach” of corporate raiders, but with the creation of the junk bond, all companies in the United States came within the reach of well-funded organizations. So, finance could now reach the largest, as well as the smallest, businesses.

This evolution, of course, continued into the 2000s. The point is that as information becomes available it can be used in many different ways to serve many different purposes. “Slicing and dicing” the information known as cash flows is not new, but is a part of a process that has a long history. And, due to the nature of information this process is not going to go away.

The Obama administration is now making its attempt to re-regulate financial institutions and financial markets. The proposal offered yesterday is much watered-down from what the “more progressive” wing of the political spectrum had wanted: its thrust is not sufficiently “Rooseveltian”. Still others express concern that the administration is going too far in some areas.

My take on the Obama proposals for financial regulation: it will make little difference in the end. Obama needs to take some kind of action and look like he is attacking the problems faced by the society. In the longer run the new regulatory scheme will make very little difference.

Financial innovation is going to continue. If some efforts are constrained in the United States, they will pop up elsewhere in the world. The incentives to innovate are still there. If we force the innovation to go off-shore, then we are, in my mind, the losers. This innovation will help others but provide little benefit to us.

What is needed? To me the most important thing that is needed is openness and transparency. We need to know what is being done and by whom. As derivative securities and hedge funds grew and prospered, we heard over and over again that they could not tell anyone what they were doing because, if they did, the narrow spreads they were working with would go away. Well, guess what! Most everyone knew what deals were being struck and the spreads went away anyway. That is why these organizations needed to use more and more leverage to take on riskier and riskier deals.

Highly competitive markets where there are few if any barriers to entry cannot continually provide exceptional returns. “Trading” is not the source of sustainable competitive advantage and keeping things secret will not salvage trading schemes. Openness and transparency will result in financial institutions focusing on what really creates competitive advantage and what is sustainable. This is necessary for the existence of a strong and healthy financial system.

Secondly, we need methods to close or put-out-of-business in a more timely fashion financial institutions that are troubled or are insolvent. Re-instating and improving mark-to-market accounting is a must. Increased openness and transparency should help the market place carry out this function, but, the regulatory system needs to have more FDIC-type efficiency to move quickly into institutions and shut them down. (The Federal Reserve is not the institution to do this. It needs to keep its focus on the conduct of monetary policy.) Moving quickly to resolve problems has always been the best policy. Managing institutions based on wishful thinking, a major trait of the banking system, is not a good policy.

We need financial regulation and oversight, just as we need periodic checkups and advice from doctors. However, there is only so much that regulators can do. Unlike our physical systems, our financial systems are going to innovate and change. My guess is that in the future with the continued advancement of information technology financial innovation will continue to increase rapidly and will serve as the model for more and more of our non-financial markets. “Information markets” is the model for the future. This innovation will, in one way or another, get around whatever regulation that is imposed. That is why openness and transparency is so important. But, that is also why the system of failure and bankruptcy should be enhanced and enforced. These, to me, are the major requirements we should impose on the financial system.

Sunday, June 14, 2009

What Banks Aren't Telling Us?

I am still worried about what banks aren’t telling us.


Total Reserves in the banking system have increased by $857.8 billion over the twelve month period ending in May 2009. Excess reserves in the banking system have increased by $842.1 billion in the same time period.

The Federal Reserve System has overseen a 1,900% increase in total reserve in the banking system, year-over-year, for the year ending May 2009, and banks have chosen to sit on the injection almost dollar-for-dollar!

These figures come from the Federal Reserve statistical release H.3 “Aggregate Reserves of Depository Institutions and the Monetary Base.” I have used the “not seasonally adjusted” data.

This is unheard of! In May 2008, excess reserves were $2.0 billion and stood at 4.5% of the total reserves in the banking system. In May 2009, excess reserves totaled 93.7% of the total reserves in the banking system.

Unless someone can convince me otherwise there are, in my mind, only three reasons for this behavior. The first is the volume of bad assets currently on the balance sheets of banks that have not been recognized. The second is the volume of bad assets that banks anticipate will be forthcoming over the next year or so. The third has to do with how the banks have funded themselves in the past several years.

If these assumptions are correct, the recession cannot be called over yet and any economic recovery that might be forthcoming is going to be relatively tepid or postponed for some time. I obviously hope that I am wrong but something just does not “foot” with the data that I have reported above.

In the first category, current bad assets on the balance sheet, one would think that we know a fair amount about them. Their volume was sufficiently large so that the government put into place the TARP program and then followed that up with the idea of the P-PIP. Several banks feel sufficiently strong that they are returning their TARP money and it appears as if the P-PIP will never be actually implemented.

Financial markets have responded favorably to these events. Yet, we know that there still remain a large number of bad assets in the banking system. The current confidence has allowed some banks to return the TARP funds wanting to get the “Feds” out of their buildings and out of their compensation committees. In addition, with the relative calm in both financial and economic markets, confidence has risen within the banking system that maybe they can ride out the rest of the way to recovery, hoping that many of the remaining bad assets will turnaround or be refinanced or be worked with.

In my experience working in the banking sector, “hope seems to spring eternal” when it comes to believing that bad assets will eventually become good assets. The attitude is that “with time” the borrowers will come through.

But, what kind of confidence is it that sits on $844.1 billion in excess reserves, funds that are earning no return to the banks? Required reserves in the banking system in May only totaled $58.8 billion. What am I missing?

Let’s look at the second category, that about debt coming due or repricing in the future. We have seen more and more reports in recent weeks about the Option Mortgages that are coming due over the next 18 months or so; we read about all the commercial mortgage debt that is on the edge and this was accentuated this week with the bankruptcy filing of Six Flags; and we know that credit card delinquencies are still rising. What we don’t know is the extent of the fallout from the bankruptcies in the auto industry and how this will impact those industries and regions that have depended upon a healthy car business. In addition, personal bankruptcies and small business bankruptcies continue to rise and there is really no firm information about when the increase in these will moderate and what the effect on the banking system will be.

Finally, there is the problem of financing the banking system itself. I recommend that you take a look at the article by Gretchen Morgenson in the June 14 New York Times, “Debts Coming Due at Just the Wrong Time.” ( Morgenson writes about the debt of the banking system and the need for bank balance sheets to shrink. The banking system, itself, needs to de-leverage and may have to do so unwillingly.

In this article, Morgenson refers to a study by Barclays Capital that discusses the amount of debt of financial companies coming due over the next year or two. The figures, roughly $172 billion of debt will mature in the rest of 2009 and $245 billion will mature in 2010. This means that financial institutions will have to refinance about $25 billion a month for the next 18 months or so. Part of the problem in refinancing this debt is that “many of the entities that bought this debt when it was issued aren’t around any more.” Furthermore, in general, “few buyers of short-term bank debt are around now.”

Raising equity capital is fine, but, over then next few years, the banks may have a larger hole to finance in terms of the debt that it must try to roll over. This, of course, will put more pressure on the policy makers. The policy makers have gone out on a limb in attempting to protect the need to write down bad assets. The policy makers have provided capital for some of the banks that were in the worst financial shape. The next issue has to do with the need for the purchase of bank liabilities. This may be a very tough balancing act to complete successfully.

But, maybe the government has already provided the funds to meet these emergencies. Maybe that is why banks are holding such large amounts of excess reserves. They know that over the next 18 months that they are going to have a severe funding problem. Excess reserves are the perfect answer to paying off the debt as it runs off, leaving the banks with a lot of funds that still can buy them time to “work out” the bad assets that remain on their balance sheets.

Thursday, June 11, 2009

The BRICs Are On The Move!

In the midst of the current economic and financial crisis the world is radically changing. Comparisons are constantly being made between the collapse of the global economy that is now being experienced and the collapse the world went through in the 1930s. Whereas most of the discussion has limited itself to the extent of the downturn and the methods being used by policymakers to avoid a repeat of the severity of the earlier depression, I would like to focus on another area in which comparisons can be made. The specific area I would like to focus upon is the relative shifts that are taking place in economic and financial power in the world.

At the start of World War I there was no question that Great Britain was the number one economic and financial power in the world. The 1920s and the 1930s represented a turning point in the economic structure of the world and a change in the location of the center of financial power. The change in economic structure related to the final triumph of the industrial sector over the agricultural sector in the most advanced countries in the world. This movement favored the United States over Europe. The center of financial power in the world shifted from London to the United States. The changes in industrial structure helped to explain parts of the economic dislocations of the Great Depression that were not fully absorbed until World War II. The shift in financial power was not really recognized until after the war.

An important and interesting history of this period can be found in the book “Lords of Finance” by Liaquat Ahamed. I have written a review of this book for Seeking Alpha and this can be found at

I am bringing up this history because I believe there is a similar shift in economic structure and financial power that is going on in the world at the present time. It is important to understand these changes because they are going to influence what is going on in the world for a long time.

Like the 1920s and 1930s there is an economic restructuring going on. To me, the emerging dislocations in the world are related to advances in information technology and the global changes in energy needs. I have no idea how these dislocations are going to work themselves out but there are huge changes coming. The innovation in financial instruments markets over the past forty years or so are the result of the new information technology and the intense study of what are now called “Information Markets” is going to lead to transactions and trading opportunities that have not fully been realized yet. I believe that the collapse of the auto industry is just one part of the mammoth changes that are coming in the area of energy sources and uses.

The other shift that is taking place is in the location of financial power within the global marketplace. Yesterday it was announced that Russia and Brazil will each acquire $10 billion of bonds from the International Monetary Fund (See Brazil, Russia Trade T-Bills for IMF Clout, China is planning to purchase $50 billion in IMF bonds and it is said that India will also make a similar purchase. The BRIC countries are on the move!

The reason given for the purchase of the IMF bonds is to increase the clout that these emerging nations have on world economic and financial affairs. The BRIC nations believe that they have earned and therefore deserve to play a bigger role in what is going on globally. Hence, the movements of these countries are not surprising and are not uncoordinated. The leaders of the BRIC nations have been meeting regularly and communicating frequently. Their next group meeting begins June 16 in Russia.

The important thing for the leadership in the United States to realize is that they must take the world into consideration when making decisions relating to U. S. fiscal and monetary policy. I have gotten comments on my recent posts about the dollar that question the need for policy makers to be concerned about the value of the dollar in their decision making. I agree with Paul Volcker that the most important price in a country is the price of its currency. The United States, even more than in the past, will not be able to afford to ignore what the rest of the world is saying about the direction its budget policy and monetary policy are going. All too often in the past, and especially in the past eight years, American leadership has thumbed its nose at world opinion. The rise of the BRICs indicates that this time is over and real attention needs to be paid to what others are saying and doing. Although the United States will continue, in the near term to be the major financial power in the world, the times are changing and will continue to move in the current direction over the next ten to twenty years.

There are two reasons for saying this. First, Brazil, Russia, India, and China are going to continue to become more powerful economically and financially. Whereas there may not be an absolute shift in world power in these areas, there will be a relative shift with the BRIC nations becoming relatively more powerful. This, in my mind, is not going to stop.

Second, some form of international organization is going to evolve that will oversee global financial institutions and financial markets. The IMF is a natural place to look for such leadership. In the past it has not quite lived up to its possibilities. Now, however, it looks as if there is a new focus on the possibilities it presents. The BRIC nations seem to be eying the IMF as a place where they might be able to exert their growing economic and financial clout to attain the recognition and influence they want and believe they deserve. The IMF is certainly not an unwilling recipient of such attention and is actively seeking more funding.

What does all this mean for investors? I would like to focus on just two points related to the financial issues. First, the United States seems headed for a clash with the rest of the world in terms of monetary and fiscal policy. The current and future budget deficits appear to be unsustainable and the Obama administration has not yet presented any credible plans to reduce the amount of debt the government will be creating. In addition, the Federal Reserve has already put so much liquidity into the financial system that Bernanke’s statements about removing the liquidity as the crisis retreats seem less than serious. The added concern is what role the Fed will play in helping the Treasury place all the debt that it must issue. As I have stated before, history has repeatedly shown that this is not a good combination either for keeping interest rates low or for keeping the value of the currency up. Such movements over time will be brought on by the international markets. The only response that will avoid this is to bring the budget under control and take the pressure off the central bank to support the placing of the debt.

The second point refers to the shift in world economic power. If the BRIC countries find that they can work with the IMF, a new power structure will emerge in global finance. Financial and non-financial companies in emerging markets will become much more relevant. Important financial centers will be distributed throughout the world rather than being concentrated in just one or two cities. As with the evolution of the financial power in the 1920s and 1930s, these changes will not take place overnight. What I am suggesting, however, is that we are seeing the beginning of a shift in financial power in the world that will continue to evolve over the next ten to twenty years.

This has important ramifications for the regulation or re-regulation of the United States financial system. As usual, Congress and the Administration are fighting the last war. Right now the policy makers in charge in Washington D. C. are responding to the populist discontent being expressed in the country. Get rid of greed! Regulate salaries and bonuses! Emasculate the role of derivatives! This is not the way to prepare the economic and financial system for the future.

Yes, the world is changing. The economic base of the global economy is shifting and the resulting need to restructure is the reason for the severity of the current recession. Financial power in the world is being re-distributed and this trend is just beginning to show itself. These movements are going to define the conditions for investment in the coming years. It will require new and creative thinking.

Monday, June 8, 2009

BRIC, the Dollar, and U. S. Monetary Policy

Over the past several months I have written regularly that the value of the United States dollar will decline over an extended period of time. The basic argument for this is that over the past forty years or so, any country that has run excessive governmental budget deficits and has not had an independent central bank has seen the value of its currency come under pressure in international financial markets. During this time, country after country has had to regain discipline over its fiscal affairs and see to it that its central bank acted more independently of the government’s budgetary affairs.

The United States has not been immune to this pressure throughout this time period. Of recent note, reference has often been made of the pressure the Clinton administration faced early on that resulted in a fiscal discipline that brought about a surplus in the government’s budget in the latter years of the administration. Of course, that discipline completely disappeared in the Bush 43 years supported by a compliant Federal Reserve System. As a consequence the value of the United States dollar decline in a relatively steady fashion from late 2001 through August 2008.

The rebound in the value of the dollar only came about as the world wide financial crisis created a movement toward United States Treasury securities and credit quality. As this movement has subsided, the dollar has shown some weakness once again.

The bet right now is that given the massive budget deficits projected for the next several years the Obama administration will find itself in the same fiscal stance that the Bush 43 administration was. But, even worse, the Federal Reserve has already liquefied the financial system and now seems to be in a position where it has to provide even more liquidity to banks in order to assist the placement of all the new governmental debt coming to market.

As almost everyone knows the Federal Reserve has more than doubled the size of its balance sheet since the first week in September last year going from about $880 billion in assets to around $2,060 billion on June 3, 2009. Total reserves in the banking system have increased by roughly 1,900% since then and excess reserve in the banking system recently have averaged slightly below the size of the whole Federal Reserve balance sheet in that first week of September last year (up from just $2 billion then). The ominous change, however, is that recently the Fed’s holdings of U. S. Treasury securities has begun to rise once again as the Fed has given more support for the bond market. The increase in the Fed’s portfolio of Treasury securities was almost $46 billion from Wednesday May 6 to Wednesday June 3.

So, the Fed has supplied a tremendous amount of liquidity to the banking system that is just sitting out there waiting to see what further solvency shocks it will have to face. (See my post of June 4, 2009, Even though Chairman Bernanke has promised that the liquidity will be removed from the financial system once the need for it goes away, it is hard to see how all these funds will be taken away in a reasonable period of time. Furthermore, if the Federal Reserve is under pressure to support the forthcoming supply of new Treasury issues it is hard to see how it can both reduce its balance sheet while at the same time provide support to the bond market: especially if it has already started with this support.

It, therefore, seems as if there is some justification for participants in international financial markets to be concerned about a further decline in the value of the United States dollar. The scenario unfolding in the United States has all the components to it that international markets reacted against in the past forty years or so. And, the promises of the Obama administration to bring the federal budget under control with savings resulting from the, as-yet, unknown health care program appear to be grossly optimistic, at best.

There is another factor looming on the horizon that has not been present in earlier discussions about the value of the dollar. Over the past forty years or so there never has been a question raised about the role that the United States dollar plays in the international financial system. Over the past six months this topic, something that was unthinkable before, has been raised by the leaders of several countries.

In my estimation we are a long way from de-throning the United States dollar from its lofty position. However, one must take into consideration the fact that this idea is even being seriously floated in the world today. This points up the fact that the fiscal and monetary position of the United States government is being questioned and this only provides additional evidence of the weakness of the dollar in world markets.

The primary concern is being expressed by the BRIC countries, Brazil, Russia, India, and China. These are the countries that are closing the economic gap between themselves and the United States. Not that the United States will lose its Number One position as an economic power: just that these countries are coming on fast to reduce the difference. And, as these nations become more powerful relative to the United States, more and more attention is going to have to be paid to their economic and financial issues and concerns.

The BRIC countries are in a bind right now and the tension is only going to grow. These countries tend to be exporting countries and therefore must accumulate foreign exchange. The United States dollar has been the currency of choice in the past. Now, however, their large dollar holdings are “at risk” because a decline in the value of the dollar will only hurt them. As a consequence they have kept the dollar from falling further than it would have otherwise by buying large amounts of U. S. dollars. In May, the BRIC countries increased foreign reserves by more that $60 billion in an effort keep the dollar from falling further than it did. In fact, these nations are adding to their dollar reserves at their fasted pace ever.

Yet, at present, there is no alternative for them to chose. One analyst has stated that discontent with the dollar is increasing, yet nobody knows what needs to be done. Hence, the frustration with the situation has been expressed by leaders from Russia, China, and Brazil. This feeling has risen to the surface in Germany where last week German Chancellor Angela Merkel verbally took on the central banks of the United States and England for their loose monetary policies.

This is a situation that is only going to get worse before it gets any better. One can talk all they want to about the possibility of inflation and when or if inflation is actually a fear that should be present in the United States at this time. The problem is that the correlation between excessively large governmental budget deficits and loose monetary policy is too high for participants in international financial markets to ignore. Furthermore, the power of the BRIC countries is growing and their needs and desires are going to have to be accounted for. And, within these latter countries there is the stunning rise of China. Given all the economic and financial turmoil in the world, China is probably going to achieve a more prominent world role even faster than anyone expected.

The world has indeed changed. Whereas the United States has not given enough attention over the last forty years to the value of the dollar in international financial markets, it is going to have to do so going forward. The Obama administration cannot afford to casually claim to want a strong dollar and then ignore the fact that it continually declined in value the way Bush 43 did. The rest of the world will not allow this to happen.

Thursday, June 4, 2009

P-PIP, R. I. P.?

Shall we say, Rest In Peace to the P-PIP? Considered from its beginning as an ill-conceived program of the Treasury Department, the Federal Deposit Insurance Corporation has delayed a test auction for the placement of toxic assets which seems to unofficially declare P-PIP DOA. The sooner this effort is totally put to bed the better off we will all be.

P-PIP was always conceived as a program to deal with the illiquidity of bank loans and securities. The difficulty with this is that the real problem was one of solvency. That is, the problem was not about the sale-ability of the loans or assets. The problem was that the banks would need to take such a large write-down of asset values if the solvency of the loans and securities were truly accounted for that the banks, themselves, would face the threat of insolvency.

The P-PIP was an attempt to limit the write-down in asset values so that the banks would not have to directly face the insolvency issue. The Federal Government would use tax-payer dollars to provide the floor for the write-downs. This would avoid, in the minds of government officials, an alternative to “nationalization” of the banks.

The environment has changed. Now that emotions have settled down a little bit, banks (and regulators) are dealing with the loan and securities problems a little more calmly. They are attempting to “work things out” and not “run for the doors.” The ability of banks to raise more capital has also contributed to this new, calmer atmosphere.

In a credit bubble, like the one created by the Federal Reserve earlier this decade, the economic system becomes more and more fragile as institutions seek to achieve adequate returns by manipulating their financial structure. As spreads narrow, management efforts to earn competitive returns focus more and more on financial engineering such as taking on more and more risky assets, and, financing these assets with more and more leverage and by shorter and shorter term liabilities.

The real crisis occurs when the bubble pops and everyone runs for the door at the same time. The Federal Reserve created the incentives that resulted in the financial engineering and since the engineered structures, at some point, become unsustainable the following collapse becomes systemic!

Financial innovation and the creation of derivatives and other financial instruments over the past forty years or so has made the financial markets more efficient--except when everyone tries to leave the game at the same time. The real problem is that financial innovation cannot make up for bad government policy, especially if the central bank is not independent of the government of a country.

When the bubble bursts there is at first fear, as everyone realizes that they are highly exposed. Then, things settle down a bit, but still there is a high level of emotion as people look for short-cuts to get out of their positions. Then people begin to look at their portfolios more realistically and start to work through the problems they identify.

The one real crucial element in moving to this last position is fully understanding and accepting how bad the problems are. Having worked in three bank turnarounds I understand how important it is for the managements of these organizations to face their situation realistically. One can only work one’s way out of a difficult situation if one is completely honest about what needs to be done.

It appears that in the last month or so, more bank managements have moved toward a realistic approach to working out their asset problems. Things are not rosy yet, but things have calmed sufficiently so that banks have raised additional capital where they can and they have weighed the trade-off between selling assets into a P-PIP like program and decided that they are better off relying on their own efforts than those of the government. A good choice in my mind!

There are still going to be bank failures. In fact the number of bank failures projected for this year has ranged from 100 to 1,000. In order to help work through these failures, the FDIC has presented a program to deal with the troubled assets of failed banks that is modeled upon the Resolution Trust Corporation. This program will provide debt guarantees to organizations issuing debt used to buy the troubled assets of failed banks. This seems like a more legitimate way to work with private interests in settling the affairs of banks that have already gone into receivership.

Good riddance to the P-PIP if, in fact, the idea of the P-PIP is expiring. We need to move on and we need to move on where ever possible without the government playing an excessive role in the solution. The problems are not over, but the problems of financial institutions need to be handled by the financial institutions themselves. But, if everyone is not running to the door at the same time the financial system should be able to work through their difficulties.

In no way does this mean that things will be easy. Information released yesterday indicates that bankruptcies, both personal and commercial, continue to increase. Personal bankruptcies in May ran in excess of 6,000 per day, up about 150 per day over April, and commercial bankruptcies rose to 376 per day, up about 125 per day over April. Continuing at this pace, bankruptcy filings could reach 1.5 million this year. And, the full impact of the collapse of the auto industry is still to be felt.

P-PIP may be going away, but the financial crisis has not yet expired. The good news is that financial institutions are now going about their business in a more orderly manner. The bad news is that the bad news with respect to financial institutions is not going to go away.

Furthermore, the bad news is that working through these problems is going to take a long time. The good news is—that they can be worked through.

Monday, June 1, 2009

An Option on Monetization and Inflation

You want to place a bet on future inflation? Well, an opportunity for you to bet on inflation is now in the works. The hedge fund Universa Investments L. P. is planning to open a fund in the near future that will allow you to back up your concern with the possibility that inflation is coming around the corner.

The fund will invest in options tied to commodities and Treasury bonds, among other things. The strategy is a “Black Swan” strategy aimed at taking advantage of wide swings in the prices of these assets.

Of course, the fund is connected with Nassim Nicholas Taleb, the infamous author of the best sellers “The Black Swan” and “Fooled by Randomness.” To Taleb, the probability that high rates of inflation might result from the stimulus efforts of governments around the world has substantially increased. This means that the possibility of a “fat tail” event happening, the chance that hyperinflation might occur, is a reasonable wager.

Mr. Taleb, in an interview, argued that “We think these things are going to see massive volatility.” These things being the price of corn, crude oil, copper, the stocks of oil drillers and gold miners, and the price of Treasury bonds and the value of the United States dollar. (For a more information see, “Black Swan Fund Makes a Big Bet on Inflation,”

This effort is nothing new. It is just a high profile attempt to do what international investors have done for the last fifty years. (I know, it has been done for longer than that but I am just focusing on the modern era of imprudent government budget management.) And, there has been nothing more successful than betting against large fiscal deficits that put pressure on central banks to monetize the debt. The examples are numerous; see George Soros, the British Pound, and 1992 and Fancios Mitterand, the French Franc, and 1983 and more! The currencies of countries following Keynesian policies in which government budget deficits were used to stimulate economic growth and low levels of unemployment were easy targets for the international investment community.

Of course, inflation is not a problem now. And, many would argue that deflation is the real near term threat. Yet, the United States government, among others, is following a very “Keynesian” stimulus program with deficits that dwarf anything that has been seen in the past. The Federal Reserve System has forced an enormous amount of reserves into the banking and financial systems. For example, the year-over-year rate of increase of total reserves in the banking system was over 1,900% in April. The Fed’s purchase of mortgage-backed securities stood at $428 billion at the close of business on Wednesday May 28.

Chairman Bernanke has stated that the Fed will “reverse out” of these positions once the economy begins to pick up some speed. He may believe this and be very serious about achieving this end. BUT, there still are the large government deficits. How is the Fed going to handle them?

Not very easily, as is evident from the behavior in the bond market over the past couple of weeks. In fact, history is on the side of those that believe that the Fed cannot control long term interest rates over the longer run. Central banks all over the world have tried before, but success has only come in the short run and at the expense of monetizing too much of the government debt. This is the worldwide experience of the past 50 years! Governments all over the world have not been able to successfully combat the will of international financial markets if the participants in these markets believe that the fiscal policy of a government is not being conducted in a prudent manner.

The Federal Reserve got the first real taste of this in the last two weeks. There is more to come. The cycle is that the central bank tries to keep down long term rates by buying government securities. This is successful for a while, but the market observes that the central bank is monetizing the debt and so more pressure is put on bond prices forcing long term interest rates higher. Continued central bank efforts to hold down rates only result in the purchase of more government securities which then leads to more market concern about this monetization of the debt. Another round of central bank activity can follow. This picture of the dog chasing its tail only ends in frustration for the central bank and finally resignation that its goal cannot be achieved.

And, all during this time, the value of the currency of the country falls. Sound familiar?

When does the inflation occur?

That is uncertain. It will occur some time in the future. We know, however, that with large amounts of uncertainty, volatility increases.

In the meantime, you have a good argument for buying options which is what the Universa effort is going to do.

The question then becomes one about whether or not another Black Swan will occur. How are you betting?